Related party transactions are inevitable in business and they are often discussed in accounting due to their risky nature. These transactions are always under scrutiny since there’s a higher fraud risk or can generate misstatements in the financial statements. Auditors and investors usually pay close attention to those related party transactions. Accounting standards also mandate companies to disclose related party transactions. How do companies identify related party transactions and what is considered a related party? We will discuss this topic in this article.
What is a Related Party Transaction?
A related party transaction is an agreement between two parties that have an existing relationship with each other. The relationship could be with shareholders, with management, family relationships, business relationships, parent company and subsidiaries, parties that have the same interests, just to name a few.
Related party transactions are essentially close relations between two parties and because of the closeness, those types of transactions are prone to conflict of interest and are at higher fraud risks. Two parties that are related could transact with each other in a more favorable treatment versus two parties that are not related. Regulations require that related party transactions are disclosed in financial statements but they can be easily hidden on purpose or because sometimes they can be missed by mistake.
How to Identify Related Party Transactions?
Related party transactions can either be very straightforward or very difficult to identify. Unfortunately, there is no secret formula to recognize related parties or transactions involving related parties. It requires knowledge and experience in knowing a company’s profile and who they do business with. We will discuss some methodologies that can help in identifying related party transactions.
- Identifying the related parties to a company is the first step since knowing who the related parties are will help in finding transactions that occurred with related parties. List all persons or entities that are related from management, family members, directors, officers, shareholders, subsidiaries or parent companies, joint ventures etc.
- Review the listing of customers and look for any names or big relationships that can be an indicator of a close relationship.
- Review the listing of suppliers and look for any names or big relationships that can be an indicator of a close relationship.
- If a company has board meetings, any important or risky transactions should be discussed in those meetings so having a review of the meeting minutes could give insight on any related party transactions.
- Look for any transactions that seem unusual and not recurring every year. Those might be an indication of one-off related party transactions.
- Identify if there are any transactions that seem to be too good to be true or at unreasonably low amounts. Since related parties have close relationships, they could have concluded a transaction at an unusually favorable amount.
- Any non-monetary transactions could be an indicator of related party transactions so should be looked into further.
- Look at any material transactions that involve acquisitions or dispositions of assets as these might be completed with related parties.
As mentioned, the above lists only a few methodologies in identifying related party transactions. The important thing to remember is to stay alert when trying to identify any related party transactions.
Once related party transactions are identified, it’s paramount to determine whether these transactions have been made in the normal course of business, meaning there were no favors given to the other party and the transactions were completed with terms similar to any transactions with other non-related third parties.
Further, it’s also important to ensure the terms of any agreement with related parties are done on an arm’s length basis. When a transaction is done on an arm’s length basis, it means that two parties that enter into an agreement are both acting for their own best interest and one party is not influencing the other in the way they make their decisions.
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Related Party Transactions: Final Thoughts
Identifying related party transactions is an important part of accounting and financial reporting so understanding what constitutes a related party transaction is the first step. Remember that any parties that have pre-existing relationships with each other could be a related party. Failure to identify related party transactions could result in sanctions due to the high level of risk they involve and how intensely scrutinized they are by various regulators, auditors or investors. The biggest questions to ask yourselves when trying to identify a related party transaction is to determine if the transaction has been agreed in the normal course of business and that agreements are on arm’s length basis.
